Corporate Takeovers and Poison Pills

It’s hardest to forgive those who have misused your money. Corporate executives entrusted with their shareholders’ capital sometimes squander this wealth on lavish salaries and lackluster investments. Shareholders can theoretically fire corporate executives who prove unworthy of their trust. Incompetent executives, however, often use poison pills to protect their power.

A poison pill gives its owner the ability to destroy shareholder assets. Having the ability to destroy, however, also gives one the capacity to protect. For example, after Internet stocks started to decline, many dot.com companies like Yahoo adopted poison pill defenses to protect their managers from ouster.^[6] Before considering poison pills and their relationship to game theory, I will first provide some background on shareholder democracy.

When you buy a share of stock, you acquire an ownership interest in a company. Corporations are democracies in which you usually get one vote for every share you own, and companies are supposed to be run for the benefit of the stockholders, because they are the true owners. Just as elected government officials don’t always serve the best interests of their country, however, corporate executives don’t always run their companies in the best interests of their shareholders, as has been seen in recent years with Enron and Tyco. Shareholders, theoretically, have the right to replace poorly performing corporate executives. Unfortunately, most shareholders don’t follow closely what happens in their companies. If you own stock in 100 firms, it’s probably not worth your time to determine which ones are well run, so most shareholders don’t really value their stock’s voting rights and almost never attempt to unseat incompetent executives.

Corporate raiders, however, sometimes use hostile takeovers to expel incompetent management teams. Here’s how it can work: Imagine there are 10,000,000 shares of Acme outstanding, so having one share gives you 1/10,000,000 ownership of Acme. Let’s say that a share of Acme currently sells for $10 and thus the total market value of Acme is $100 million. A corporate raider believes that shares of Acme are selling for only $10 each because Acme’s executives are fools. This corporate raider feels that if people she picked ran Acme, its share value would increase to $15. At its current price the raider could buy 50 percent of the shares in Acme for $50 million. After acquiring half of the shares, the raider could fire the current management and put in her own people. If the raider could then increase the value of Acme’s stock to $15 a share, she could then sell her 5,000,000 shares of Acme for a $25 million profit.

Raider’s Plan

Buy 5,000,000 shares of Acme at $10 each taking control of 50 percent of company.

Replace management and raise share price of Acme to $15.

Sell all 5,000,000 shares earning a profit of $25 million.

The preceding scenario could take place only if the original executives were hyperpassive. No one enjoys being fired, and in the United States a highly paid employee about to lose his job instinctively turns to lawyers for help.

Wall Street lawyers devised poison pills to protect incumbent executives from corporate raiders. A poison pill gives executives the ability to reduce their company’s stock value. For example, a poison pill could force the incumbent management to give all employees a $50,000 bonus if any outside investor acquires more than 20 percent of its company’s stock. If some investor went above this 20 percent threshold, management would have the right, but not the obligation, to swallow the poison pill. While such bonuses would benefit workers, they would, of course, harm stockholders.

Now, imagine that you are a raider thinking of taking control of the company that has such a bonus poison pill. You wouldn’t want the company if the pill was going to be swallowed. But should you believe that the board of directors would ever decimate its own company? Is the executive’s threat to use the poison pill credible?

People aware of their impending termination tend to get angry. If the incumbent managers knew that they were going to be terminated, then they might use the bonus poison pill to take revenge on their tormentor, the corporate raider. Of course, the executives probably own stock in their company. Eating the poison pill would hurt them as well as the raider.

In his game with the company, the raider moves first. The raider initially decides whether to cross the 20 percent threshold, and then the executives determine whether to swallow the pill. If activating the poison pill would stop the raider and protect the managers’ jobs, then perhaps the managers would use their pill. Giving large bonuses to all employees, however, should not stop the raider from taking over the company if he already owns 20 percent of it. The poison pill reduces the value of the company and harms the raider. It also, however, lowers the company’s stock price and so makes it easier for the raider to acquire the additional shares he needs to take control of the company.

Furthermore, once the poison pill harms the raider, the raider cannot mitigate the pill’s harm by backing down. The poison pill inflicts a sunk cost upon the raider. Once incurred, sunk costs should be ignored because you can’t do anything about them. Figure 7 shows why, once the poison pill has been activated, the raider should ignore its effects. This figure assumes that taking over the company gives the raider $25 million, while the poison pill costs him $30 million. If the pill is consumed, the raider can’t retract the bonuses. Taking over the company gives the raider $25 million, netting him a loss of only $5 million. Once the poison pill is used, therefore, the raider might as well continue replacing the incumbent management.

Figure 7

Of course, if the raider knows at the beginning of the game in Figure 7 that the managers will activate the poison pill, then the raider should leave the company alone. While the poison pill won’t stop a raider who has already acquired 20 percent of Acme, it would stop the raider from even attempting to take over Acme if the raider believes that the pill would be implemented. The pill deters the raider, however, only if he believes that it will be used. Unfortunately for the incumbent executives, other than the joy they get from revenge, they receive no additional benefit from destroying the value of their company. Indeed, since they almost certainly own shares in their company, eating their poison pill will actually make them worse off, so their threat to use the poison pill lacks credibility.

To protect their jobs, managers need a more credible device such as a dilution poison pill. If a corporate raider acquired more than 20 percent of a company’s stock, a dilution poison pill could result in every shareholder except the raider receiving an additional share for each one he owns. This would dilute the raider’s interests and help the other shareholders. Consequently, the incumbent management would be willing to use this poison pill since that would cause its ownership interest in the firm to increase. A corporate raider facing a company that had a dilution poison pill would therefore be extremely reluctant to initiate a hostile takeover.

Dilution poison pills protect incompetent managements and so usually harm shareholder interests. Indeed, Fidelity Investments, an extremely large institutional investor, has a policy of withholding support from corporate managers who enact new poison pills.^[7] Theoretically, though, ordinary shareholders could benefit from a dilution poison pill. Such a poison pill would force any potential corporate raider to get permission from the board of directors before acquiring the company. If the board of directors were really concerned with the interests of its shareholders, the board could use the poison pill to negotiate a better deal for the takeover and force the raider to pay more for the company. Recall in our example that Acme’s stock originally sells for $10 a share, and the raider believes that if he were in control, he could increase its value to $15 a share. The raider’s plan is to try to buy half or more of the stock of Acme for $10 a share. If the raider has to negotiate with the board before getting more than 20 percent of the company, the board could force the raider to pay, say, $13 a share rather than just $10.

This poison pill tale illustrates the essential nature of credible threats. Let’s say I want to credibly threaten to hurt you in July if you do something I don’t like today. My threat is credible only if it would actually be in my self-interest to hurt you in July if you harm me today. Consequently, when making a threat, ensure that it’s a threat you will want to carry out.

^[6]Red Herring (May 31, 2001).

^[7]Wall Street Journal (June 12, 2002).